The petrodollar story has a little bit of everything. Hope, ambition, political intrigue, mystery, treachery, greed, deceit, betrayal, despair, poverty, envy, wealth, frustration, anger, courage, rage, conflict, revenge, retribution and more and more and on and on it goes …

I'm sure there's a great book to be written or movie to be made – one which uses the petrodollar as its backdrop. A minor epic perhaps. All that's needed is a bit of romance – but just for artistic license – because there's nothing romantic about what actually went on.

It's a story which hasn't finished yet – but it will – and the ending's not likely to be a happy one.

Long after its demise historians will refer to it as an experiment. It may even go down in history as "The Petrodollar Experiment", perhaps followed by a subtitle which reads something like, "Fiat Money's Last Hurrah!" – which would be an apt and fitting epitaph by itself.

But time will tell.

What follows is a base document which I hope will not only inform, but will also raise interest in a subject which, inspite of its critical importance, has received little attention in the mainstream media.

It splits quite well into three parts.

Part 1 – Where it came from and how it worked

Following World War II an international system was set up whereby the US dollar (USD) became the world's reserve currency. Each USD was backed by a fixed amount of gold. The deal was that any country which held USDs always had the option of exchanging them for gold. The idea was to create greater confidence and stability in international trade – which it did – for about twenty years.

This agreement put the USA in a particularly advantageous position; not dissimilar to a commercial bank operating a fractional reserve banking system.

Valéry Giscard d'Estaing famously referred to it as an "exorbitant privilege", way back in the 1960s.

Which is what it was.

And one which was open to abuse.

Which is what happened.

Whilst it was understood that America would have to "put the dollars out there" in order for the thing to work, no-one foresaw the massive increases in government printing and spending which would be required to fund, amongst many other things, the escalating cost of the war in Vietnam.

By the late 1960s it became pretty obvious that the volume of USDs floating around the globe was far in excess of the amount of gold which should have been available to back them up. What then ensued, after a series of financial scares and crises, was the equivalent of a bank run – let's call it a gold run – with the French leading the charge.

The outflow of gold from Fort Knox reached such alarming proportions that Richard Nixon was forced to call a halt to convertibility on August 15, 1971. This was supposed to be a temporary measure.

But as Milton Friedman would say, "Nothing is so permanent as a temporary government program."

And so it was.

The dollar, no longer backed by anything, became a pure fiat currency and soon began to lose value against other currencies. OPEC continued to price its oil in USDs but then saw it was losing money and started to consider using other currencies or even gold.

A new big idea was urgently required in order to restore the USD to its former position.

Move aside Machiavelli - enter Henry Kissinger!

The story goes that in 1973 Nixon dispatched him to Saudi for a series of secret high-level talks.

By the end of it, one year later, a deal was made:

"Amazingly, a new system was devised which allowed the U.S. to operate the printing presses for the world reserve currency with no restraints placed on it-- not even a pretense of gold convertibility! …This gave the dollar a special place among world currencies and in essence backed the dollar with oil." - Ron Paul.

As the most powerful member of OPEC, Saudi soon roped in the other members.

"By 1975 all of the members of OPEC agreed to sell their oil only in US dollars. Every oil-importing nation in the world started saving their surplus in US dollars so as to be able to buy oil; with such high demand for dollars the currency strengthened. On top of that, many oil-exporting nations like Saudi Arabia spent their US dollar surpluses on Treasury securities, providing a new, deep pool of lenders to support US government spending."

He continues:

"The "petrodollar" system [as it came to be called] was a brilliant political and economic move. It forced the world's oil money to flow through the US Federal Reserve, creating ever-growing international demand for both US dollars and US debt, while essentially letting the US pretty much own the world's oil for free, since oil's value is denominated in a currency that America controls and prints. The petrodollar system spread beyond oil: the majority of international trade is done in US dollars."

Put simply, if countries wanted to buy just about anything from other countries, not just oil, they needed to have USDs. If they couldn't borrow them they had to go out and earn them!

The power and privilege which this conferred on the USA would not be relinquished easily.

Why did OPEC leaders agree to this?

There were two main reasons.

The first is to do with the nature of cartels. The only way the thing would work long-term (i.e. the only way to deter individual members from cheating) was to ensure all trade took place in a single traceable currency. At the time the USD fitted the bill; under this agreement it would again become to be the world's safest, most stable and most trustworthy medium of exchange.

The second was that America promised protection to OPEC leaders against foreign invasion or domestic uprisings. The system remained in place, unopposed and unchallenged, for the next twenty five years.

One can only imagine the resentment, frustration and anger felt by ordinary people in the Middle East, when they compared their situation and their non-development, to countries like India and China over the same period. Their hatred festered, not just for their rulers, but for every successive American administration which kept their subjugators in power.

But nothing lasts forever.

In the year 2000, the first major challenge to the petrodollar system was launched by Saddam Hussein.

If one had any doubts, that by this time American foreign policy was primarily about protecting the petrodollar system, then what happened subsequently would have laid them to rest.

Part 2 – When and why it started going wrong

Let's continue the story with another quote from Marin Katusa, not only someone who knows what he's talking about, but someone who can actually write:

"Until November 2000, no OPEC country had dared to violate the US dollar-pricing rule, and while the US dollar remained the strongest currency in the world there was also little reason to challenge the system. But in late 2000, France and a few other EU members convinced Saddam Hussein to defy the petrodollar process and sell Iraq's oil for food in euros, not dollars."

This was not only the first direct revolt against the petrodollar system but also something which started a ball rolling:

"In the time between then and the March 2003 American invasion of Iraq, several other nations hinted at their interest in non-US dollar oil trading, including Russia, Iran, Indonesia, and even Venezuela."

When the invasion did happen, the reason given was Saddam's alleged possession of Weapons of Mass Destruction.

As we all know now, this was a complete fabrication.

In reality, the invasion was supposed to accomplish two things. First, to undo any damage done to the petrodollar system; and second, to act as a deterrent to others who tried to break away.

As things turned out it failed in both respects. It was too late. The cat was out of the bag.

"The system would be [directly] challenged a second time, this time by Libya. In February of 2009, Muammar Gaddafi was elected the chairman of the African Union and would continue the effort to create the United States of Africa, which among other things, would include a unified currency, a dinar based on gold. Gaddafi went so far as to suggest that the African nations' oil trade would be switched from the dollar to this new gold currency."

This challenge was far more dangerous than the first. Had he been allowed to go ahead the USD would almost certainly have collapsed. Like Saddam he also got the treatment – only this time it was far more swift – and far more brutal. The excuse for the intervention was another lie – i.e. "humanitarian" reasons – go here for the background.

The third challenge actually started in 2003 - when Iran announced its intention to abandon the petrodollar system - and has been ongoing ever since.

"Early in 2008, Iran launched a new commodity exchange known as the Iranian Oil Bourse. The intent was to allow for Iranian oil to be priced and traded with multiple currencies. As the system was ramped up, initially the exchange limited its trade to secondary petroleum products, with crude oil to be added "when the system was ready." Iran … announced it would be ready on March 20, 2012. This was a declaration of war on the petro dollar!"

"Japan, China, India and Turkey are among the countries who've been dependent on Iranian oil to some degree. Various discussions have been taking place between Iran and its trading partners on the possibility to enlist trade for other commodities such as gold or grain."

One cannot help being cynical about the timing of the sanctions and the reason given – Iran's nuclear ambitions.

Be this as it may, the history of sanctions is that they may bite at first, but never really pan out as planned – if at all. Those against Iran will go the same way. Further, there's little doubt that many other countries will be encouraged to also find different ways of paying for their oil.

Which brings us to something else which has been going on increasingly over the previous ten years or so.

I refer to the growth in "currency swap" agreements – especially in the last two years. Not only a quicker and cheaper method of doing things but also a way out of America's stranglehold on international trade and everything else to do with the USD.

This trend is not going to change.

Which brings us to the heart of the matter.

The only thing which keeps the American economy going is debt. The only thing which attracts lenders is the strong dollar. The only reason for the strong dollar is the petrodollar system.

As demand for the USD drops, the government won't receive enough money to pay all its bills, interest rates start to rise and then all sorts of horrible things begin to happen.

That the dollar will collapse is inevitable.

But what will it mean?

Marin Katusa, ending on an optimistic note, does not consider its demise will be such a disaster. As I've stolen so much from him in this essay already, I see no reason to stop now.

So here's some more:

"2012 might end up being most famous as the year in which the world defected from the US dollar as the global currency of choice. Imagine the rest of the world doing the math and, little by little, beginning to do business in their own currencies and investing ever less of their surpluses in US Treasuries. It constitutes nothing less than a slow but sure decimation of the dollar.

"That may not be a bad thing for the United States. The country's gargantuan debts can never be repaid as long as the dollar maintains anything close to its current valuation. Given the state of the country, all that's really left supporting the value in the dollar is its global reserve currency status. If that goes and the dollar slides, maybe the US will be able to repay its debts and start fresh. That new start would come without the privileges and ingrained subsidies to which Americans are so accustomed, but it's amazing that the petrodollar system has lasted this long. It was only a matter of time before something would break it down."

The key point in this quote is where he writes about, "a slow but sure decimation of the dollar". If this indeed is what happens we are left with some hope – not much – but at least a glimmer that the road ahead will not be quite so bad.

However, if this is not what happens – and the dollar collapse is sudden – then the future is grim.

And there's no way of sugar-coating it.

But, as mentioned, there is still a glimmer of hope.

To understand the what and the why, we need to take a few steps back in time; to something which happened back in the 1980s – on September 22nd 1985 to be precise - in the Plaza Hotel in New York City.

Part 3 – Where are we now and what happens next?

Let's first pick up where we left off.

In the first half of the 1980s the USD appreciated to the point where American exporters were having a very hard time of it. The driving forces behind the over-strong dollar were the petrodollar system itself and high interest rates.

Through a concerted campaign of protests and lobbying, exporters eventually spurred the White House into action.

To cut a long story short, finance ministers from the world's leading economies at the time, met in the Plaza Hotel in New York City in September 1985. They reached an agreement; by acting in concert they would bring about a controlled fall in the value of the dollar. This would be done by actively intervening in currency markets around the world.

Over the next two years things did not work out exactly as planned, but they did achieve their primary objective – a significant devaluation of the USD against its major foreign competitors.

The crucial point is that this agreement was not made in secret – was not made behind closed doors. Their intentions were announced in advance and then carried out in an orderly fashion and in such a way that it did not lead to financial panic in world markets.

However, there is something to bear in mind - this particular method of devaluation was only possible for the USD – simply because of its unique position as the world's reserve currency.

Not so for other countries and their currencies.

Fast forward to present day America.

As laid out in Part 2, the petrodollar system is beginning to come apart.

The USA is bankrupt and has been so for a very long time. No big secret here. The only reason foreigners continue to lend, thereby putting off the day of reckoning, is because of the petrodollar system. But the more this system weakens, the more downward pressure there is on the dollar and the closer the USA gets to a belated sovereign debt crisis.

Such a crisis happens when a government cannot repay its debts to foreign lenders.

Once it gets underway events usually move very quickly.

To deal with the situation, governments have a few options, but almost invariably choose to default. This means lenders will usually not get all of their money back – in some cases they get nothing.

Also, if governments choose the default option, creditors have no recourse in law. They must suffer any losses.

What form the default takes depends on the circumstances and what agreements, if any, are reached. For example, a country could choose to repudiate all or part of the debt. Alternatively they may choose to restructure their debts in some way through devaluation, alteration of terms and conditions or some combination thereof.

If the worst comes to the worst they may choose, or even be forced, to print their currency out of existence!

There is absolutely nothing new in any of this. The number of countries who have found themselves in a such a position over, say, the last hundred years is quite staggering. In fact, if a continental-type gold cup were to be awarded, it would have to go to the countries which comprise Central and South America!

Needless to say, these countries have not disappeared, they are still with us – but they all had to face consequences for their defaults. Not least the immediate plunge into recession which followed and the fact that people will always think twice before ever lending them money again.

However, the fact remains – one way or another - these countries came through it.

At which point the average reader in America may start to wonder – what's all the hand-wringing about – why not just repudiate the lot?

Screw you, we ain't payin'!

Tempting as it may be to think like this, especially given the hatred which so many countries bear against America, such a sudden move would be catastrophic. Not just for America but for the global economy. Whereas other countries can stiff whoever they like and start again, America is not like "other countries". If it were to default everyone else would have to "start again" as well.

Nobody needs a degree in economics to figure out why.

America is still far and away the most powerful economy on the planet. It is also the world's greatest consumer. To put it bluntly, if the American economy goes down the toilet it takes everyone else with it.

No.

Default by the USA is not an option – it's not in anyone's economic interest - it's a negative sum game.

Therefore the downward slide in the dollar must be managed in such a way as to try and ensure there is no sudden collapse

Which brings us back to the Plaza Accord.

Can it be done again?

Agreed, it was a long time ago. And yes, the reasons are very different this time – to slow down the slide in the dollar – rather can bring it about. Also, much has happened between then and now – so many things have changed greatly – not least the economic rise of China.

But what other option is there – do nothing and wait until it hits the fan?

Hardly.

Two questions to finish with.

First. If it were possible to again manage a controlled fall in the USD, would this be enough to avoid disaster?

Not by itself – no – it is a necessary condition but not a sufficient one. Other things need to be going on at the same time, which work together to bring down the overall size of the debt – down to a level which is at least manageable.

The Romney/Ryan approach aims to achieve this by growing the economy using supply-side policies.

The current administration, totally bereft of ideas, offers nothing more than more of the same.

Second. As the petrodollar system collapses and the USDs role as reserve currency erodes, what will emerge to replace it?

Crystal ball time …

In the short to medium term, "currency swap" agreements may develop into something a bit more ambitious – perhaps resembling an idea floated by Lord Keynes at Bretton Woods – the Bancor – and maybe, for a time, variations on this will operate on a regional basis.

Who knows?

However, in the end there can only be a return to the one true world currency – the currency of choice, freely made by people over thousands of years – I refer of course to gold.

When asked if he would see a return to the gold standard in his lifetime, Peter Schiff replied quite simply, "Yes, I will - it has to happen."

I take this as a prediction. Given his track record, I wouldn't bet against it.

Chris Clancy lived in China for seven years. Most of this time was spent as associate professor of financial accounting at Zhongnan University of Economics and Law in Wuhan City, Hubei Province. He now lives in Thailand where he spends his time reading, writing, lecturing and, whenever he gets the chance, doing his level best to spread Austrian economics.